The influence of labor market rigidity on the performance of fiscal policy

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The influence of labor market rigidity on the

performance of fiscal policy

Bachelor Thesis Faculty of Economics and Business Edited by: Jacob Bakx Supervised by: N. Ciurila

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Abstract

The beginning of the ‘Great Recession’ in 2008 has renewed attention on the

discussion of fiscal policy and its impact on the economy. Besides that, many countries within the European Union implemented structural labor market reforms in order to stimulate the economy. This paper studies how the flexibility of the labor market influences the conduct of fiscal policy in two EU countries. In particular, the implementation of austerity measures in Greece and Ireland. By performing a data analysis, it can be concluded that the rigidity of the labor market negatively influences the outcome of fiscal consolidations.

Statement of Originality

This document is written by Jacob Bakx, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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1. Introduction

Fiscal policy is one of the instruments of governments to influence the economic state of a country. Since the financial crisis, the ECB cut interest rates to zero, shifting the focus of many macroeconomic discussions to fiscal policy (Mankiw, 2013, p. 596).

There are two main movements in relation to the impact of fiscal policy on the economy. Firstly, there are adherents of the (new) Classical school of thought, who believe that fiscal policy can have no real effects in neither the short or long run and find that the less the government intervenes with the free market, the better. On the other hand there are economists who follow the Keynesian school of thought; they believe government policies can have a positive real effect on the economy, but only in the short run. A third movement named the ‘German view’ by Giavazzi and Pagano (1990) is growing popularity. In this view, economists believe that austerity measures could result in an overall economic expansion.

Research on the effects of fiscal policy has been done extensively. Fontana (2009) says that academics and policymakers have achieved a high level of consensus on monetary policy and its effects on the economy. However, there is not anything like approaching a convergence of views about the impact of fiscal policy on the economy. Also, Alesina and Ardagna (2010) still argue that this question has not been answered yet. Overall, the literature has proven a strong disagreement amongst economists about whether tax cuts or spending increases are more expansionary.

During the ‘Great Recession’ budget deficits severely increased which destabilized the economy even more. In order to prevent a further decrease in confidence and economic stability many EU countries began implementing fiscal consolidation measures (measures that include spending cuts or tax increases). The main goal of austerity measures is to decrease the debt-to-GDP ratio. A more favorable outcome would be an increase in the GDP growth rate. Such an increase is called a non-Keynesian effect of fiscal consolidation and can arise due to an overall higher consumer and business confidence. In particular, this effect arises when consumers expect the reduction in government spending to be permanent because this way it eliminates the expectation of a future tax increase. Another way this effect could arise is when interest rates drop. Lower interest rates imply a higher present value of private wealth, thereby reducing risk premiums on sovereign debt and stimulating short-run investment (Alesina and Perotti, 1997; Giudice et al, 2003).

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Factors that have been found relevant for characterizing episodes of expansionary consolidation are the size of fiscal adjustment, the composition (tax increase or spending cuts) and the initial debt-to-GDP ratio (Giudice et al, 2003). Giudice et al. (2003) showed that the composition of the adjustment affects the outcome the most.

First of all, in this study is given an overview of the research done into austerity and its effect on economic growth.

By calculating the fiscal (government expenditure/taxation) multiplier, economists can show how effective the implemented policy was. The aforementioned fiscal multiplier is defined as a change in output relative to a change in government spending or tax revenue. Batini et al. (2014) presented key structural and temporary factors that influence the fiscal multipliers calculated by economists. One of these factors is labor market rigidity.

Auerbach and Gorodnichenko (2012) find that as the rigidity in the labor market rises, the output response in recession increases and the cyclical variation in the size of the fiscal multiplier, calculated with a SVAR methodology, becomes more apparent. In their research, they used two measures of labor market rigidities constructed in the article of Botero et al. (2004).

It was found that the rigidity of the labor market smoothens or hampers GDP growth. As a result, high labor market rigidity could, for instance, lower competitive advantage by making firms unwilling to establish factories in a certain country what consequently slows down national GDP growth. On the other hand, due to workers protection, which is a characteristic of labor market rigidity, economists expected a big increase in the rate of unemployment, since the beginning of the ‘Great Recession’, to be less likely. A smaller contraction in the unemployment rate reduces the negative change in real GDP. After analyzing these and many more factors it is important to separate the labor markets of each country into two categories, flexible and inflexible, and compare every country’s GDP growth since the start of the fiscal consolidation measures implemented by its government.

In this study, the influence of labor market rigidity on the performance of fiscal policy will be investigated. The analysis compares the annual growth rate of 2 countries namely Greece and Ireland, over period 2005-2015. Despite the fact that both countries are members of the EU, they differ greatly in their labor market policies and institutions. The investigated period is relevant because the view of economists on the conduct of fiscal policy changed a lot since the beginning of the ‘Great Recession’ in 2008. Furthermore, by choosing years before and after the implementation of fiscal consolidation, the different outcomes of fiscal consolidation can be compared. At first, by looking at the cyclically adjusted budget deficits,

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episodes of fiscal consolidation are identified. Thereafter indicators of labor market rigidity and the annual GDP growth rates are collected from the OECD database and the ICTWSS database.

Relating to the influence of labor market rigidity on the implementation of economic reforms, Forteza and Rama (2000) have conducted a research where they compared annual growth rates for 119 countries over period 1970-1986. Although in this paper a substantially smaller country sample is investigated, by focusing on countries that use the same currency it is possible to remove the differences in comparative advantage or disadvantage generated by exchange rate mechanisms.

Forteza and Rama (2000) showed that labor market policies and institutions have an impact on the effectiveness of adjustment programs supported by the World Bank and the IMF. Their results indicate a negative influence of inflexible markets on economic recovery.

In this paper, a similar conclusion will be expected. Thereby hypothesizing that the country with the most flexible labor market will have experienced the most growth since the implementation of fiscal consolidation. This hypothesis is based on the expectation that due to the flexibility of labor markets, there will be a smaller increase in the unemployment rate, as response to the ‘Great Recession’ and subsequent implementation of austerity measures.

Freeman (1992) also investigated the influence of institutional interventions on the effectiveness of economic reforms. His findings contradict those of Forteza and Rama (2000) since he found little evidence of the fact that regulated markets could hinder stabilization programs.

First, the general definition of fiscal consolidation and its effect on output are reviewed. Second, the interaction of labor market rigidity and fiscal consolidation is

explained. Third, the data analysis of the relationship between fiscal policy and labor market flexibility is conducted. The final section contains a summary and a concluding remark.

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2. Fiscal consolidation

In this section, the definition, background and thorough literature review of fiscal consolidation measures are given.

2.1 Definition of consolidations

The main purpose of a fiscal adjustment is to correct for unexpected shocks in the economic cycle like the recent financial crisis. More specifically, fiscal adjustments correct for shifts in the cyclically adjusted budget balance. The CABB is one of the key indicators for the analysis and conduct of fiscal policy, particularly in the EU (Larch and Turrini, 2010). It can be computed by trying to measure how the economy stands relative to its potential level. When calculating this difference one should take into account the sensitivity of the budget balance. In other words, how the components of the budget balance usually react to shocks in the economy.

The way consolidation is defined has varied greatly in past literature. The definition used in this paper is equivalent to the definition formulated for example by the European Commission (2008) and Alesina and Ardagna (2010).

A period of fiscal adjustment is an improvement of the cyclically adjusted budget deficit by at least 1.5% of GDP in a single year (Alesina and Ardagne, 2010; European Commission, 2008). The European Commission (2008) also defines a period to be a consolidation period when the improvement of at least 1.5% of GDP is achieved over the course of three years, in each single year the improvement of the CABB is less than 1.5% of GDP and the CABB does not deteriorate by more than 0.5% of GDP compared to the year before. This way, the European Commission divides consolidation episodes into two types: cold shower and gradual episodes. In this study, the definition formulated by the European Commission is followed, because combining the definitions is more relevant for an empirical analysis since it will increase the number of useful observations.

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2.2 Circumstances of fiscal consolidations

The need for fiscal consolidation measures since the beginning of the financial crisis was immense. Cyclically adjusted budget deficits increased to over 5% of GDP for Southern countries such as Greece, Spain, and Portugal. Even economically healthier countries like the Netherlands and Germany experienced an increase to over 2% of GDP. This was a strong violation of the Stability Growth Pact, which is an agreement between all the EU countries. The main purpose of this pact was to keep government deficits below 3% of GDP and consequently maintain economic stability within the EU. Fiscal consolidation measures were therefore inevitable and by 2011 most European countries significantly decreased their budget deficit.

Besides a large debt ratio, some other variables could trigger a fiscal consolidation. Von Hagen and Strauch (2001) clarify these variables with the use of a probit regression on a set of economic conditions in OECD countries. They found that of significant importance is how well a countries’ economy is doing relative to other economies. If a countries’ fiscal stance is excelling that of other countries its policymakers tend to reduce spending or increase taxes. Furthermore, a large output gap increases the probability of launching austerity

measures. Finally, governments are more likely to start fiscal consolidations if the stand towards contraction is increasing in countries related to theirs. Also, Molnar (2013) used a probit estimation to examine the determinants of the start of consolidation periods. Her findings were similar to those of Von Hagen and Strauch (2001), only adding one important finding: the influence of political economy factors. Political economy factors can be divided into the following elements: i) newly elected governments are more likely to launch

adjustment programs and ii) far away from the center governments are less likely to launch adjustment programs (Molnar, 2013).

Identifying and taking all these variables into account, when making the decision to launch an adjustment program, is extremely relevant, since timing is crucial. Barrios et al. (2010) provide evidence that suggests that fiscal consolidation is less effective when it is started while a financial crisis is still underway. This will be kept in mind during this paper especially since the finding is only applicable for EU countries and not for non-EU OECD countries (Barrios et al, 2010).

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2.3 Composition of the adjustment

A fiscal adjustment can be composed in two different ways: tax-driven or spending-driven. The composition influences both the duration and the successfulness of the

adjustment. But these findings go hand in hand since the higher the effectiveness of the consolidation, the shorter the duration. Whether it should consolidate by increasing taxes or reduce spending is probably the most important question for a government. An abundant supply of literature is available in which economists are trying to answer this question. The overall conclusion seems clear: retrenchments based on expenditure cuts are found to be more effective (Molnár, 2012). One important explanation, given by the European Commission, is that cuts mostly go along with attempts to increase public services' efficiency. Where tax-increases signal a weak commitment to developing structural reforms and may be viewed as a decrease in social security (Kumar et al., 2007). Such a signal can be very harmful to growth.

Erceg and Lindé (2012) investigated the effect of spending cuts and tax hikes in a monetary union and got opposite results. A large expenditure cut can increase output losses and stop growth, especially at the zero lower bound. They argue that a combination of the two is the most favorable strategy.

Expenditure cuts can even be expansionary; Alesina and Ardagna (2010) found various periods of spending cuts followed by economic growth. Lots of papers similar to Alesina and Ardagna’s paper have been written about the expansionary effects of fiscal consolidation but those will be reviewed in the final paragraph of this section.

2.4 The size of the adjustment

Before going over the actual composition of the fiscal adjustment and what kind of factors have proven to be the most successful, it is important to determine the impact of the size of the adjustment on the probability of being successful. A successful consolidation episode is one leading to a reduction of the debt level by at least 4.5-percentage points GDP after 3 years. As mentioned in the first paragraph, fiscal consolidations can be separated into two types: a ‘cold shower’ fiscal adjustment and a ‘gradual’ fiscal adjustment. In general, gradual adjustments seem to be more successful. But this difference decreases when considering consolidations during or shortly after a period of large debt increases, which is the case in Europe (Barrios et al, 2010).

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2.5 Effects of fiscal consolidations

Extensive evidence has been found of the fact that fiscal adjustments not only stabilize the economy but also cause economic expansion. Giavazzi and Pagano (1990) were the first to come up with the existence of non-Keynesian effects of fiscal consolidation. This effect can go through both the consumption channel and the investment channel. If agents believe the tax increase or spending cut to be permanent then it will have a positive effect on output by an increase in current consumption and demand. Through the investment channel, fiscal policy can have an expansionary effect via the labor market. A reduction in spending can cause downward pressure on wages by firms in need to reduce labor costs. In the end, fewer labor costs boost investment. This highly depends on the credibility of the government and its adjustment, which are all influenced by the composition of consolidation. Besides the fact that both types are completely different, the nature of each type can differ as well. Spending cuts can be divided into cuts in wages, consumption, investment, subsidies etc. Increases in tax revenues can be due to an increase in corporate income taxes, property taxes, VAT etc. Every one of these ‘sub-categories’ affects the economy in its own way.

On the one hand, many researchers are convinced that expenditure cuts are more expansionary than revenue increases. Whilst on the other hand, researchers have seen the most favorable outcome when the adjustment is a mix of both types. A good understanding of the impact of austerity is essential but a final consensus is still far away. Many types of research are opposed to the implementation of austerity as they see it as a policy that reduces growth and may in the long term even cause a higher debt to GDP ratio. These opposing views will be discussed later on.

In order to analyze the effect of fiscal consolidation, several methods have been used like descriptive analyses, probit regressions, estimation models, case studies and more.

2.5.1 Expansionary fiscal consolidations

Alesina and Ardagna (2010) performed a case study analysis on 21 OECD countries; they scholars searched for major changes in fiscal policy and looked at the behavior of fiscal and macroeconomic variables after these major changes. Their conclusion in regards to fiscal adjustments is that successful adjustments are completely based on big spending cuts along

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with modest tax cuts. They found that both consumption and investment grow during expansionary episodes.

Similarly, Attinasi and Metelli (2017) studied the effect of fiscal consolidation using a VAR on a panel of 11 Euro area countries. Their conclusion is mostly in line with that of Alesina and Ardagna regarding the composition of the adjustment. One important addition is the fact that a consolidation based on the revenue side can cause the debt-to-GDP level to fall back to its pre-shock level and will be, as they call it ‘self-defeating'. Another remarkable finding is that when they control for initial conditions, especially episodes of financial distress, countries instantly benefit from a reduction in spending. Long-run benefits of fiscal consolidation are more likely to occur when the moment of implementation is in times of prosperity.

With the use of probit regressions, Giudice et al. (2007) were able to prove that periods of expansionary consolidations occur more often when output is below potential.

While the countries in the EU started fiscal consolidation measures the ECB tried to enhance growth conducting a quantitative easing program. One could argue that in the case of an acceleration of growth this is caused by QE. Giudice et al. (2003) found that monetary easing may increase the likelihood of expansionary fiscal adjustments but that it is not a crucial requirement to show non-Keynesian features.

Baldacci et al. (2014) reach rather different conclusions than the four previously examined papers. They show that during normal times gradually paced fiscal adjustments are positively influencing growth, while large deficit cuts can have a contractionary effect. In times of high debt and restrained lending to the private sector, for example, when the government is deleveraging the banking sector, a fiscal mix of spending cuts and revenue increases has the highest chance of inducing growth.

2.5.2 Contractionary fiscal consolidations

For others, proof of expansionary fiscal consolidations is inaccurate, and they discredit the implementation of such a policy during a financial recession. Many researchers are of the opinion that the established method of computing the effects of fiscal adjustment is biased towards the favorable outcome of fiscal adjustments being expansionary. With this method, economists identify changes in the CABB and argue that these changes are caused by fiscal policy measures. Guajardo et al. (2011) claim that these changes are mainly due to

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developments, such as booms in stock markets that are not attributable to fiscal policy. Also spending based retrenchments are growth reducing, with a decrease in both private

consumption and private investment.

In order to tackle this persisting problem, Fidrmuc et al. (2015) proposed a new method different from the ones previously treated. In their research, they created a new way of computing the CABB, including economics booms or busts and country-specific factors. In this way, they tried to take into account the critics of Guajardo et al. about the traditional method. Their result is striking, based on all the fiscal adjustments identified, it seemed that the short-term effect of austerity measures on growth is mostly contractionary. In general, non-Keynesian effects will not occur. A finding that is in line with most results generated is that spending cuts will do less harm to output than tax increases will.

Fatás and Summers (2015) increased the time horizon investigated and also concluded that the long run effect of fiscal consolidation can be negative. They argued that austerity measures might even increase debt-to-GDP ratio.

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3. Labor market flexibility

There is no doubt about the influence of labor market flexibility in shaping economic outcomes. Lieb (2012) stated that in the European monetary and fiscal policy design, real wage rigidity could hardly be ignored. In order to determine the degree of impact on the economy researchers developed multiple empirical models.

Firstly, in this section, a general definition of labor market flexibility is presented. Secondly, the interaction between labor market rigidity and fiscal conduct is discussed.

3.1 Definition of labor market flexibility

A key issue for policymakers is choosing the ideal degree of labor market flexibility, in labor utilization, labor mobility and wage setting (Kahn, 2011). Labor market flexibility is the pace at which labor markets adjust to asymmetric macroeconomic shocks. One way through which this adjustment mechanism works is through the change in wages. Real wages adjust to equilibrate labor supply and labor demand; failure to equilibrate the labor market results in unemployment. The more rigid wages are, the slower the adjustment of labor markets is. Also, the structure of the labor market seems to have a significant impact on the way firms adjust to economic shocks. Friedman first mentioned the importance of wage flexibility to win competitiveness within a currency union, because exchange rate

mechanisms could no longer be used. This importance grew even bigger for countries that became a member of the European economic and monetary union because adjustment through migration and fiscal transfers were limited also (Allsop and Artis, 2003).

As empirical evidence suggests, those countries that are characterized by a more flexible labor market, have managed to limit unemployment rate increases since the beginning of the crisis (di Mauro and Ronchi, 2016). So in addition to the budgetary adjustments made by countries in the Eurozone, many countries carried out major labor market reforms. In particular those that were heavily affected by the crisis, with the aim of stimulating the economy by deregulating the labor market.

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3.1.1 Characteristics set by the ECB

There are several variables that influence the level of wage flexibility. In 2015 the ECB gave an overview of those variables. These variables are minimum wage laws, union density, coordination of wage bargaining and the level at which bargaining takes place. In this paper, the overall level of labor market flexibility is going to be judged on the basis of these variables, which is similar to the method used by the OECD in their 2012 Employment Outlook.

Minimum-wage laws are laws set up by a government to put a legal minimum on the wages that firms pay their employees. This is a way to raise the income of the people.

Union density is the proportion of workers that is a member of a union. This is different from the percentage of workers that are covered by collective bargaining, because when unions ‘collectively bargain', which can be done on a national, sectorial or firm level, they also cover workers that are not a member of their union. Besides negotiating about wages, unions also represent workers on different topics like working conditions and hours of employment.

3.1.2 General factors

Additional to wage flexibility and the variables set by the ECB there are more factors that influence the flexibility of the labor market.

This includes the mobility of labor, which can be divided into three variants, namely geographical mobility, which is the ability to move from one area to another. The greater the degree of geographical mobility the more it reduces the impact macroeconomics shocks have on diversified economies, like in the EU. Another variant of labor mobility is industrial mobility, the ability to switch industries. The final variant is the occupational mobility, which is the volition and ability to move from one job to another. A higher degree of occupational mobility often goes hand in hand with a larger proportion of part-time workers and hence a more flexible labor market.

Another important factor is the way social security laws are set up. This can be judged by looking at various aspects: the unemployment benefits, the sickness, and health benefits and the old age benefits. Extremely generous benefits may reduce flexibility since it has a negative impact on the willingness of the unemployed to search for a new job.

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The final factor of importance is a body of law presented by Botero et al. (2004), which is composed of employment laws, the aspects of these laws can increase or decrease the flexibility on the demand side of the labor market. They include: the cost of increasing hours worked, the cost of firing workers and the procedures of dismissal.

3.2 Interaction between labor market rigidity and fiscal policy

This research aims at finding the impact of labor market rigidity on the conduct of fiscal policy and in particular on the conduct of fiscal consolidation. Alesina et al. (1998) and Alesina and Perotti (1997) point out the importance of labor markets on the macroeconomic effects of fiscal consolidation. They found that successful consolidations reduce government spending on wages and do not increase labor taxes, unlike unsuccessful adjustments where the opposite measures were used. Furthermore, they identified a fall in unit labor costs and the wage share shortly before and during successful consolidations, but this did not happen during or before unsuccessful consolidations. These differences could be explained by the variety in labor market dynamics and institutions.

The economies in their sample are all characterized by a different degree of union centralization and thus a different outcome of their implemented fiscal adjustment. When a fiscal adjustment is composed of tax increases, unions, and especially those in countries with a high degree of union centralization, demand for higher wages to compensate for a lower after-tax income (Alesina and Perotti, 1998). Thereby reducing the possibility of a successful result because, based on the finding of Alesina and Ardagna (1998), wage moderation is a crucial element of successful fiscal consolidations. They argue that the power of unions and above all the working of the labor market within a country are essential in determining the success of fiscal consolidations.

Moreover, De Ridder and Pfajfar (2016) investigated the effect of wage rigidities on the conduct of fiscal policy. They formulated their hypothesis based on the role wage rigidities play in New Keynesian models. In these models, sticky wages create periods of unemployment and labor market tightness (de Ridder and Pfajfar, 2016). Their results from a two-stage-least-squares regression show that in the rigid state, fiscal multipliers are

significantly higher than in a flexible state, where the multiplier is slightly negative. In other words, the more rigid the labor market is, the higher and more persistent the effects of policy shocks are. This finding is in line with that of Auerbach and Gorodnichenko (2012). In

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addition, de Ridder and Pfajfar (2016) stated that, the inability of wage cuts in rigid states generated greater unemployment and output loss when policy shocks decrease economic activity.

Furthermore, de Ridder and Pfajfar (2016) included several control variables that influence wage rigidity such as labor mobility, firm size, unionization, union power and minimum wages. Their estimation confirms that wage rigidity increases with the presence of these variables.

Turrini (2012) analyzed the interaction between fiscal policy and labor market

regulation. He did this by examining the impact of fiscal retrenchments in countries with high and low employment protection. He finds that fiscal consolidations raise the unemployment rate more in the regulated labor markets, than in the unregulated markets. This increase of the unemployment rate in countries with high EPL hampers GDP growth, and can result in a less effective use of fiscal policy.

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4. Methodology

The methodology used in this paper is a data analysis of the effect of labor market rigidities on the effectiveness of fiscal policy. By collecting the data on the characteristics of labor market policies the degree of labor market flexibility can be determined. After that, the way both labor markets responded to the new economic conditions is compared. Finally, the linkage between the degree of flexibility and GDP growth is discussed.

4.1 Cyclically adjusted budget balances

In the tables below are the cyclically adjusted budget deficits (hereafter CABB) presented of the countries examined in this study: Greece and Ireland. They both experienced a period of fiscal consolidation based on the two definitions of fiscal consolidation formulated in the second section of this paper. The investigated period is 2005-2015. This data is

collected from the Directorate General for Economic and Financial Affairs Economic Forecasts database.

Table 1

Cyclically adjusted budget balance Greece 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 As % of GDP -5.2 -7.0 -8.0 -10.6 -14.9 -8.6 -5.4 -3.1 -6.7 2.8 0.9 Change from previous year - -1.8 -1.0 -2.6 -4.3 6.3 3.2 2.3 -3.6 9.5 -1.9 As % of potential GDP -5.2 -7.1 -8.3 -10.7 -14.7 -8.2 -5.0 -2.7 -5.9 2.5 0.8

Source: DG ECFIN Economic Forecasts

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Cyclically adjusted budget balance Ireland 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 As % of GDP 1.1 1.6 -2.1 -8.0 -11.6 -28.6 -12.5 -7.9 -6.5 -4.3 -4.2 Change from previous year - 0.5 -3.7 -5.9 -3.6 -17.0 16.1 4.6 1.4 2.2 0.1 As % of potential GDP 1.1 1.6 -2.2 -8.1 -11.1 -27.4 -12.4 -7.9 -6.4 -4.3 -4.2

Figure 1: Cyclically adjusted budget balance change as % of GDP, 2006-2015

Looking at figure 1, Greece and Ireland did not simultaneously experience periods of fiscal consolidation. Greece’s fiscal imbalances started to develop long before the beginning of the ‘Great Recession’. When the CABB reached its lowest level in 2009, structural economic reforms were necessary to stabilize the level of debt. In 2010 Greece started a period of fiscal consolidation by cutting government expenditure and increasing revenues. These austerity measures were accompanied by a €110 billion bailout launched by the EC,

-18% -14% -10% -6% -2% 2% 6% 10% 14% 18% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Greece Ireland

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ECB, and IMF. After a decrease of the CABB in 2013, which was partly caused by a major bank recapitalization, Greece stated a budget surplus in 2014 for the first time in more than 20 years. Over period 2009-2012, Greece decreased its balanced budget deficit by a total amount of 11.8% of GDP. Then again, in 2014, it reduced its CABB by 9.5%, accounting for one more year of fiscal consolidation.

From 2009 to 2010, Ireland experienced a huge decrease in their cyclically adjusted budget balance due to a major bank bailout implemented by the Irish Government. They initiated a €64 billion bank bailout for the six main Irish Banks in order to save them from becoming insolvent. After this big increase in government deficit, interest rates started to rise and further borrowing became impossible. In response, Ireland was forced to accept an economic bailout from the European Union by the end of 2010 on the condition of imposing extensive austerity measures. Thereafter the period of fiscal consolidation started with a rise of 16.1% in the CABB. This rise cannot be regarded as a regular fiscal adjustment since the large deficit in 2010 is caused by a one-time expenditure. Still, in 2011, general government spending, as a percentage of GDP, has been reduced to an amount below that of 2009, the year before the bailout.

As of 2012, Ireland experienced minor positive changes in their CABB ascribable to cutting government expenditure and a successful economic bailout program. In total, Ireland reduced its budget deficit by 24.1% of GDP over period 2011-2014.

4.2 Labor market flexibility

There is lots of literature available about the effect of labor market rigidity on

macroeconomic variables such as output, unemployment, trade, private consumption, etc. In this paragraph, some methods of defining the degree of labor market rigidity are being reviewed.

Kahn (2012) compares the level of labor market flexibility by looking at descriptive information about wage setting institutions and policies across big OECD nations. In order to do this he provides three tables with data on union density, collective bargaining, employment protection and minimum wages. This method is similar to the method used by the ECB and the OECD.

Another common way to proxy labor market rigidities is by using information on the rate of a countries’ acceptance of labor law covenants set up by the International Labor

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Organization. Van Beers (1998), Rodrik (1996), Siroén (2012) did their investigation using this estimate of labor market rigidity.

The OECD Employment Protection Legislation indicator has also been applied as an estimate of labor market rigidity. This indicator measures the expenses and procedures involved in hiring and dismissing laborers or groups of laborers. But the indicator only refers to a small part of the variables that influence labor market flexibility; so only using this might give an inconclusive result. Two articles where this indicator has been used are articles written by Roy (2016) and Egger, Greenway, and Seidel (2011).

The way the degree of flexibility is determined in this paper is based on the

institutional characteristics of trade unions, wage setting, state intervention and social pacts. The data on these characteristics is taken from the ICTWSS database. Besides these

characteristics, the earlier mentioned EPL indicator is compared as well.

In order to ensure that the degree of labor rigidity in practice is a valid estimate of the labor market rigidity on paper, the number of ILO conventions ratified is also reviewed.

The data on the characteristics of labor market flexibility, taken from the ICTWSS database, is available over the period 1960-2014. On almost all the characteristics the data of the years 2015 and 2014 is missing but since labor market policies and institutions evolve gradually over time, it is possible to assume that the level of rigidity remains relatively stable (Forteza and Rama, 2000). Apart from the structural labor market reform programs between 2009 and 2011, this assumption also holds for the countries examined in this investigation.

Out of the assembled data (presented in the appendix), it can be concluded that the Irish labor market is more flexible than the labor market of Greece. The largest difference in flexibility is based on employment protection legislation, which is approximately twice as much in Greece as in Ireland. While the Irish market was relatively flexible at the beginning of the crisis and deregulated even more in 2009, Greece entered the crisis with an inflexible market and began deregulating its labor market as late as 2011.These reforms included the decentralization of wage bargaining and the reduction of employment protection legislations. It must be kept in mind that due to time lag of government policies, the actual effects of these reforms may still have to occur.

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4.3 Labor market responses

Even though the harshness of the ‘Great Recession’ has been comparable in these two countries, the way their labor markets adjusted has differed depending on the level of rigidity. When labor markets are rather inflexible, like in Greece, and wage bargaining takes place at a centralized level, firms are more likely to lower labor costs by dismissing employees. On the contrary, in the less regulated markets that are faced with a negative shock, firms can lower wages in order to cut labor costs. This trend is shown in Ireland where as a consequence of the unstable economy a sharp increase in the unemployment rate occurred. To reduce the negative impact of the macroeconomic shock, wages were adjusted downward and unit labor costs decreased. Eventually, the rise in the rate of unemployment stabilized in 2011 and fell after 2012. Because employed workers increase output and unemployed workers do not, this decline should be associated with an increase in GDP. Which is clearly the case in Ireland where GDP growth returned to a positive level in 2013 and from that time forward increased together with a decreasing rate of unemployment.

At the same time, the unemployment rate kept rising in Greece until 2013. This is no coincidence since countries with stronger EPL typically are associated with a stronger

reduction in the creation of jobs and a higher rate of long-term unemployment (Turrini, 2012). The rigidity of Greece’s labor market, and in particular the highly centralized

coordination of wage bargaining limited firms to adjust wages and cut labor costs. Only after 2011, the year where Greece implemented major labor market reforms, employee

compensation, and unit labor costs reductions took place. As mentioned before, a decline in unit labor costs, as well as wage moderation, increase the likelihood of a successful

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Figure 2: Unemployment rate as % of total labor force

Source: OECD

Figure 3: Employee compensation by activity as % gross value added

Source: OECD 0% 5% 10% 15% 20% 25% 30% Greece Ireland 0% 10% 20% 30% 40% 50% 60% Greece Ireland

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Figure 4: Unit labor costs per employee as % change since previous year

Source: OECD

4.4 Outcome of fiscal consolidations

The main goal of austerity measures is to reduce a government’s debt-to-GDP level. Figure 5 shows the debt-to-GDP level of both countries over period 2005-2015. It is evident that Ireland did not manage to reduce its debt-to-GDP level until 2014, the same year it stopped implementing austerity measures. Greece, on the other hand, only reduced its general government debt during the period of fiscal consolidation. However, this reduction is mostly caused by a cut on the Greek debt, worth 110 billion euro’s.

The fact that Greece was not capable of slowing down debt growth is partly explained by the increasing decline of the GDP growth rate. Already before the crisis, the growth in output and revenues earned could not compensate the rise in government expenditures. On top of that, Greece received a second bailout loan of the Troika in 2012. Consequently, the

moment Greece stopped implementing fiscal adjustments, while still experiencing negative GDP growth rates, the Greek debt-to-GDP ratio began to exponentially climb to levels even higher than before the ‘Great Recession’. Thereafter, in 2014, a second period of fiscal consolidation resulted in a stagnation of the government debt and a small increase in the GDP growth rate. In order to determine whether this last period of fiscal adjustment further

positively affected the Greek economy, the time period investigated ought to be extended. -20% -15% -10% -5% 0% 5% 10% 15% Greece Ireland

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Figure 5: General government debt as % of GDP

Source: OECD

Ireland was able to limit a further increase in the unemployment rate and reduced its government debt to a level below 100% of GDP. As can be observed in figure 6, Ireland’s fiscal consolidation measures were followed by an ascent in the GDP growth rate. This could give an indication of an expansionary fiscal consolidation. An outcome that is expected considering two statements mentioned before; according to Alesina and Ardagna (2010) austerity measures that are based on expenditure cuts are more likely to be expansionary. Where Ireland cut government expenditures by 19.3% of GDP in 2010, Greece only cut government expenditure by 1.6% in 2009. The second statement, which is in support of the various effects of fiscal consolidation in both countries, is of de Ridder and Pfajfar (2012). They found that in countries with flexible markets fiscal multipliers are slightly negative. A negative multiplier in periods of fiscal retrenchments usually means a growth in output.

Comparing both figures, it can be concluded that, Ireland experienced a period of successful consolidation together with an increase in growth, unlike Greece, that was not able to reduce its level of government debt. The structure of the labor market seemed to have played an important role on the outcome of fiscal retrenchments. More specifically, the way the labor market adjusted to the new economic circumstances is of crucial importance to successful austerity measures.

0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200% Greece Ireland

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Figure 6: Annual percentage GDP growth rate

Source: OECD -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% Greece Ireland

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5. Conclusion

5.1 Summary and conclusion

This research finds that there is an interaction between the level of labor market rigidity and the conduct of fiscal policy. First of all, it must be noted that the size of the effect depends on the way labor markets respond to macroeconomic shocks. Secondly, the degree of flexibility determines whether this effect has a negative or positive impact on the GDP growth rate.

In order to show the relationship between fiscal policy and labor market flexibility, this paper presented data on channels through which the labor market adjusts to economic shocks. The specific behavior of the labor market either hampered or smoothened the GDP growth of Greece and Ireland. As expected, the more rigid the labor market is, the less these mechanisms adjust to economic shocks. Evidence showed that the Irish economy, which is characterized by a highly flexible market, managed to limit a substantial increase in the rate of unemployment. By downward adjusting unit labor costs, firms were able to reduce their expenditures on labor. The opposite took place in Greece, where high employment protection and centralized bargaining prevented wages from falling. Consequently, long-term

unemployment increased and output lessened. There is no question that the size of Ireland’s fiscal adjustment is bigger than that of Greece. However, due to the flexibility of the labor market, Ireland was able to implement a period of successful fiscal consolidation and eventually return to a time of prosperity. On the contrary, Greece is still struggling with periods of increasing debt-to-GDP levels and a negative GDP growth rate.

In conclusion, labor market rigidity seems to have a negative impact on the effectiveness of fiscal consolidation in a period of financial distress.

5.2 Final remark

No unambiguous conclusions can be drawn from the performed analysis on the causality between labor market rigidity and the conduct of fiscal policy. This paper does not review all the variables that could have had an influence on the outcome of fiscal

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political circumstances in which these consolidation measures were implemented. Measuring the macroeconomic effects of fiscal policy is difficult, so economists still argue about its actual impact. Still, by comparing these two countries an estimation of the effect of labor market rigidities on fiscal policy can be made.

Further research could examine a bigger sample of countries over a longer period of time. To analyze this multiple econometric methods and procedures can be used.

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Appendix

Table 1

Characteristics of labor market flexibility Greece 2005 2006 2007 2008 2009 2010 2011 2012 2013 2104 2015 Union Density 24.1 24.1 24.1 23.5 22.6 22.1 22.7 22.8 21.5 - - Coordination 4 4 4 4 4 5 2 2 2 - - Level 4 5 4 5 5 5 2 2 2 - - NMS 3 3 3 3 3 3 8 8 8 - - Coverage rate 57.0 57.0 57.0 57.0 57.0 44.0 39.0 31.0 29.0 - - Regular EPL 2.80 2.80 2.80 2.80 2.80 2.80 2.17 2.17 2.12 - - Temp. EPL 2.75 2.75 2.75 2.75 2.75 2.75 2.50 2.25 2.25 - - Col. EPL 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 - - Sources: OECD Employment Database and ICTWSS Database

Table 2

Characteristics of labor market flexibility Ireland 2005 2006 2007 2008 2009 2010 2011 2012 2013 2104 2015 Union Density 34.0 32.4 31.5 31.9 33.1 32.7 32.6 31.2 29.6 27.4 - Coordination 5 5 5 5 1 1 1 1 1 - - Level 5 5 5 5 1 1 1 1 1 - - NMS 6 6 6 6 6 6 6 6 6 - - Coverage rate - - - 40.5 - - - - 40.5 - - Regular EPL 1.44 1.27 1.27 1.27 1.27 1.27 1.27 1.40 1.40 - - Temp. EPL 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 - - Col. EPL 2.75 2.75 3.50 3.50 3.50 3.50 3.50 3.50 3.50 - - Sources: OECD Employment Database and ICTWSS Database

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Legend

Union Density: union density rate is net union membership as a proportion of wage and salary earners in employment, ranging from 0 to 100.

Coordination: coordination of wage-setting ranging from 5 = centralized bargaining to 1 = fragmented wage bargaining

Level: the predominant level at which wage bargaining takes place ranging from 5 = central/cross-industry level to 1 = local or company level

NMS: Minimum wage setting ranging from 8 = wage set by government to 0 = no statutory minimum wage

Coverage rate: union coverage rate, ranging from 0 to 100. Employees covered by collective bargaining agreements as a proportion of wage and salary workers

Regular EPL: Employment protection legislation: regular employment, ranging from 1 to 6 Temp. EPL: Employment protection legislation: temporary employment, ranging from 1 to 6 Col. EPL: Employment protection legislation: collective dismissals, ranging from 1 to 6

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Data

Organization for Economic Cooperation and Development Employment Database Directorate General for Economic and Financial Affairs Economic Forecasts database – SPRING 2014

The influence of labor market rigidity on the performance of fiscal policy